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In this webcast, Saxo's global macro strategist Kay Van-Petersen, with global sales trader James Kim’s technical analysis, examines the big issues for the markets in the week ahead including the FOMC meeting chaired by Jay Powell.

A couple of weeks ago Saxobank analysts posted videos of their “Outrageous Predictions” for 2018, always a thought-provoking and entertaining watch.

One of the predictions was a big call that EURUSD will drop to parity as the Austro-Hungarian empire threatens the EU.

But what if it was to move just as far in the opposite direction ?

The European Central Bank doesn’t make predictions, let alone outrageous ones. They publish quarterly baseline “projections” that assume the oil price will move in line with the futures curve and the exchange rate will flat-line at the current rate throughout the forecast period.

Behind the scenes, Euro-system staff analysts do a “sensitivity analysis” around market pricing of key variables, based on option pricing, and publish it as part of their December macroeconomic projections for the euro area.

Accordingly, last week’s publication looked at a situation where EURUSD, instead of flat-lining out to 2020, rises to 1.3600.

Not an outrageous prediction. Indeed, not a prediction at all, but a “scenario”. It’s worth noting that in previous post-GFC reports the the sensitivity analysis was always modelled on the assumption EURUSD would decline over the projection period because of “diverging monetary policies” between the US and Eurozone.

Have ECB officials got their models in a muddle over EUR projections? Photo: Shutterstock

The staff could have stuck with the script this time around but didn’t. Perhaps they have belatedly noticed that rate differentials have not held back EURUSD this year and that diverging monetary policies are not the only factor at play.

For its part, the ECB Governing Council says the Euro-system staff projections are an “input” into their assessment of economic developments but are not “endorsed” by the council.

To eliminate FX risk, the fund manager needs to enter into a cross currency swap to borrow USD and lend EUR.

With 3 month USD Libor at 1.6%, eurolibor at -0.35% and the basis around 100 basis points, the total cost of hedging is 3%, give or take. Effectively the investors pays 1.6% to borrow USD but earns –1.35% on the euros lent.

The yield on the 10 year US Treasury bond is 2.35%. But if the cost of hedging is 3% then the investor ends up with a negative return, as shown in this chart.

Source: Bloomberg

In pre-GFC days, bank arbitrage desks would have ensured the cost of borrowing USD in the FX markets was the same as Libor, as per the law of interest rate parity.

But balance sheet restrictions mean they now have to be judicious in adding derivative exposures. That leaves to door open for financial institutions with access to USD funds - central banks, sovereign wealth funds and big US investment companies - to lend those dollars through the FX market and make a handy return.

In the above example these fund managers are able to lend USD and borrow EUR at –1.35%. Those proceeds can then be invested in short term euro-denominated securities to give a positive return.

The ECB sensitivity analysis around its latest macroeconomic projections is not a prediction as such, but it does suggest the bank sees upside risk to EURUSD.

With inflation expected to remain below target out to 2020, there will be little tolerance for the exchange rate embarking on an upward trend, thereby compounding the shortfall.

But in the short term the cross currency basis may weigh on EURUSD.

-- Edited by Adam Courtenay

Max McKegg is managing director of Technical Research Limited. If you would like to receive all Max’s Daily FX Trading Forecasts, then you are welcome to contact him here

Hih Max..interesting article.If a european investor long of euros wants to buy Us Treasury paper..why not just do the swap and you have dollars to invest..with cost around 1,95 %.If you want to sell the US paper again simply do the other side of the swap..and you are back in euros?Old dealer from Norway

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